Accounting tools for business decision making 4e kimmel 1

Accounting tools for business decision making 4e kimmel 1 Accounting tools for business decision making 4e kimmel 1 Accounting tools for business decision making 4e kimmel 1 Accounting tools for business decision making 4e kimmel 1 Accounting tools for business decision making 4e kimmel 1 Accounting tools for business decision making 4e kimmel 1

FM.qxd 11/1/10 9:11 AM Page iii Paul D Kimmel PhD, CPA University of Wisconsin—Milwaukee Milwaukee, Wisconsin Jerry J Weygandt PhD, CPA University of Wisconsin—Madison Madison, Wisconsin John Wiley & Sons, Inc Donald E Kieso PhD, CPA Northern Illinois University DeKalb, Illinois FM.qxd 11/1/10 9:11 AM Page iv Dedicated to the Wiley sales representatives who sell our books and service our adopters in a professional and ethical manner and to Enid, Merlynn, and Donna Vice President & Publisher Associate Publisher Project Editor Development Editor Project Manager Production Manager Project Editor Production Editor Senior Production Editor Associate Director of Marketing Senior Marketing Manager Executive Media Editor Media Editor Creative Director Senior Designer Production Management Services Senior Illustration Editor Senior Photo Editor Editorial Assistant Senior Marketing Assistant Assistant Marketing Manager Cover Design Cover Photo George Hoffman Christopher DeJohn Ed Brislin Terry Ann Tatro Paul Lopez Dorothy Sinclair Yana Mermel Erin Bascom Trisha McFadden Amy Scholz Ramona Sherman Allison Morris Greg Chaput Harry Nolan Madelyn Lesure Ingrao Associates Sandra Rigby Mary Ann Price Jacqueline Kepping Laura Finley Diane Mars Maureen Eide ©Peter McBride/Getty Image, Inc This book was set in New Aster by Aptara®, Inc and printed and bound by RR Donnelley The cover was printed by RR Donnelley Copyright © 2011 John Wiley & Sons, Inc All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc 222 Rosewood Drive, Danvers, MA 01923, website www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, (201)748-6011, fax (201)748-6008, website http://www.wiley.com/go/permissions To order books or for customer service please, call 1-800-CALL WILEY (225-5945) Paul D Kimmel, PhD, CPA; Jerry J Weygandt, PhD, CPA; and Donald E Kieso, PhD, CPA Accounting, Fourth Edition ISBN-13 978-0-470-53478-6 Printed in the United States of America 10 FM.qxd 11/1/10 9:11 AM Page v From the Authors Dear Student, Why This Course? Remember your biology course in high school? Did you have one of those “invisible man” models (or maybe something more high-tech than that) that gave you the opportunity to look “inside” the human body? This accounting course offers something similar: To understand a business, you have to understand the financial insides of a business organization An accounting course will help you understand the essential financial components of businesses Whether you are looking at a large multinational company like Microsoft or Starbucks or a single-owner software consulting business or coffee shop, knowing the fundamentals of accounting will help you understand what is happening As an employee, a manager, an investor, a business owner, or a director of your own personal finances—any of which roles you will have at some point in your life—you will be much the wiser for having taken this course Why This Book? Hundreds of thousands of students have used this textbook Your instructor has chosen it for you because of its trusted reputation The authors have worked hard to keep the book fresh, timely, and accurate This textbook contains features to help you learn best, whatever your learning style To understand what your learning style is, spend about ten minutes to take the learning style quiz at the textbook companion website Then, look at page xxv for how you can apply an understanding of your learning style to this course When you know more about your own learning style, browse through the Student Owner’s Manual on pages xxxi–xxxv It shows you the main features you will find in this textbook and explains their purpose How To Succeed? We’ve asked many students and many instructors whether there is a secret for success in this course The nearly unanimous answer turns out to be not much of a secret: “Do the homework.” This is one course where doing is learning, and the more time you spend on the homework assignments—using the various tools that this textbook provides—the more likely you are to learn the essential concepts, techniques, and methods of accounting Besides the textbook itself, the textbook companion website offers various support resources Good luck in this course We hope you enjoy the experience and that you put to good use throughout a lifetime of success the knowledge you obtain in this course We are sure you will not be disappointed Paul D Kimmel Jerry J Weygandt Donald E Kieso v FM.qxd 11/1/10 9:11 AM Page vi Your Team for Success in Accounting Wiley Accounting is your partner in accounting education We want to be the first publisher you think of when it comes to quality content, reliable technology, innovative resources, professional training, and unparalleled support for your accounting classroom Your Wiley Accounting Team for Success is comprised of three distinctive advantages that you won’t find with any other publisher: • Author Commitment • Wiley Faculty Network • WileyPLUS Author Commitment: A Proven Author Team of Inspired Teachers The Team for Success authors bring years of industry and academic experience to the development of each textbook that relates accounting concepts to real-world experiences This cohesive team brings continuity of writing style, pedagogy, and problem material to each course from Principles to Intermediate so you and your students can seamlessly progress from introductory through advanced courses in accounting The authors understand the mindset and time limitations of today’s students They demonstrate an intangible ability to effectively deliver complex information so it is clear and understandable while staying one step ahead of emerging global trends in business FM.qxd 11/1/10 9:11 AM Page vii Wiley Faculty Network: WileyPLUS: A Team of Educators Dedicated to Your Professional Development An Experienced Team of Support Professionals The Wiley Faculty Network (WFN) is a global group of seasoned accounting professionals who share best practices in teaching with their peers Our Virtual Guest Lecture Series provides the opportunity you need for professional development in an online environment that is relevant, convenient, and collaborative The quality of these seminars and workshops meet the strictest standards, so we are proud to be able to offer valuable CPE credits to attendees With 24 faculty mentors in accounting, it’s easy to find help with your most challenging curriculum questions—just ask our experts! 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Partner with us today! www.wileyteamforsuccess.com FM.qxd 11/1/10 9:11 AM Page viii Author Commitment Collaboration Innovation Experience After decades of success as authors of textbooks like this one, Paul Kimmel, Jerry Weygandt, and Don Kieso understand that teaching accounting goes beyond simply presenting data The authors are truly effective because they know that teaching is about telling compelling stories in ways that make each concept come-to-life Teacher / Author / Professional Through their textbooks, supplements, online learning tools, and classrooms, these authors have developed a comprehensive pedagogy that engages students in learning and faculty with teaching These authors collaborate throughout the entire process The end result is a true collaboration where each author brings his individual experience and talent to the development of every paragraph, page, and chapter, thus creating a truly well-rounded, thorough view on any given accounting topic Many Ways in One Direction Our Team for Success has developed a learning system that addresses every learning style Each year brings new insights, feedback, ideas, and improvements on how to deliver the material to every student with a passion for the subject in a format that gives them the best chance to succeed The key to the team’s approach is in understanding that, just as there are many different ways to learn, there are also many different ways to teach In Their Own Words Visit the Wiley Team for Success website to hear from the authors first-hand as they discuss their teaching styles, collaboration, and the future of accounting www.wileyteamforsuccess.com FM.qxd 11/1/10 9:11 AM Page ix Author Commitment Jerry Weygandt Jerry J Weygandt, PhD, CPA, is Arthur Andersen Alumni Emeritus Professor of Accounting at the University of Wisconsin— Madison He holds a Ph.D in accounting from the University of Illinois Articles by Professor Weygandt have appeared in the Accounting Review Journal of Accounting Research, Accounting Horizons, Journal of Accountancy, and other academic and professional journals These articles have examined such financial reporting issues as accounting for price-level adjustments, pensions, convertible securities, stock option contracts, and interim reports Professor Weygandt is author of other accounting and financial reporting books and is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Wisconsin Society of Certified Public Accountants He has served on numerous committees of the American Accounting Association and as a member of the editorial board of the Accounting Review; he also has served as President and Secretary-Treasurer of the American Accounting Association In addition, he has been actively involved with the American Institute of Certified Public Accountants and has been a member of the Accounting Standards Executive Committee (AcSEC) of that organization He has served on the FASB task force that examined the reporting issues related to accounting for income taxes and served as a trustee of the Financial Accounting Foundation Professor Weygandt has received the Chancellor’s Award for Excellence in Teaching and the Beta Gamma Sigma Dean’s Teaching Award He is on the board of directors of M & I Bank of Southern Wisconsin He is the recipient of the Wisconsin Institute of CPA’s Outstanding Educator’s Award and the Lifetime Achievement Award In 2001 he received the American Accounting Association’s Outstanding Educator Award Don Kieso Paul Kimmel Paul D Kimmel, PhD, CPA, received his bachelor’s degree from the University of Minnesota and his doctorate in accounting from the University of Wisconsin He is an Associate Professor at the University of Wisconsin—Milwaukee, and has public accounting experience with Deloitte & Touche (Minneapolis) He was the recipient of the UWM School of Business Advisory Council Teaching Award, the Reggie Taite Excellence in Teaching Award and a three-time winner of the Outstanding Teaching Assistant Award at the University of Wisconsin He is also a recipient of the Elijah Watts Sells Award for Honorary Distinction for his results on the CPA exam He is a member of the American Accounting Association and the Institute of Management Accountants and has published articles in Accounting Review, Accounting Horizons, Advances in Management Accounting, Managerial Finance, Issues in Accounting Education, Journal of Accounting Education, as well as other journals His research interests include accounting for financial instruments and innovation in accounting education He has published papers and given numerous talks on incorporating critical thinking into accounting education, and helped prepare a catalog of critical thinking resources for the Federated Schools of Accountancy Donald E Kieso, PhD, CPA, received his bachelor’s degree from Aurora University and his doctorate in accounting from the University of Illinois He has served as chairman of the Department of Accountancy and is currently the KPMG Emeritus Professor of Accountancy at Northern Illinois University He has public accounting experience with Price Waterhouse & Co (San Francisco and Chicago) and Arthur Andersen & Co (Chicago) and research experience with the Research Division of the American Institute of Certified Public Accountants (New York) He has done post doctorate work as a Visiting Scholar at the University of California at Berkeley and is a recipient of NIU’s Teaching Excellence Award and four Golden Apple Teaching Awards Professor Kieso is the author of other accounting and business books and is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Illinois CPA Society He has served as a member of the Board of Directors of the Illinois CPA Society, then AACSB’s Accounting Accreditation Committees, the State of Illinois Comptroller’s Commission, as Secretary-Treasurer of the Federation of Schools of Accountancy, and as Secretary-Treasurer of the American Accounting Association Professor Kieso is currently serving on the Board of Trustees and Executive Committee of Aurora University, as a member of the Board of Directors of Kishwaukee Community Hospital, and as Treasurer and Director of Valley West Community Hospital From 1989 to 1993 he served as a charter member of the national Accounting Education Change Commission He is the recipient of the Outstanding Accounting Educator Award from the Illinois CPA Society, the FSA’s Joseph A Silvoso Award of Merit, the NIU Foundation’s Humanitarian Award for Service to Higher Education, a Distinguished Service Award from the Illinois CPA Society, and in 2003 an honorary doctorate from Aurora University FM.qxd 11/1/10 9:11 AM Page x for Students WileyPLUS WileyPLUS is an innovative, research-based, online environment for effective teaching and learning What STUDENTS receive with WileyPLUS? WileyPLUS increases confidence through an innovative design that allows greater engagement, which leads to improved learning outcomes Design The WileyPLUS design integrates relevant resources, including the entire digital textbook, in an easy-to-navigate framework that helps students study more effectively and ensures student engagement Innovative features, such as calendars and visual progress tracking, as well as a variety of self-evaluation tools, are all designed to improve time-management and increase student confidence Engagement WileyPLUS organizes the textbook content into smaller, more manageable learning units with demonstrable study objectives and outcomes Related media, examples, and sample practice items are integrated within each section to reinforce the study objectives Throughout each study session, students can assess progress and gain immediate feedback on strengths and weaknesses in order to ensure they are spending their time most effectively Outcomes Throughout each study session, students can assess their progress and gain immediate feedback WileyPLUS provides precise reporting of strengths and weaknesses, as well as individualized quizzes, so that students are confident they are spending their time on the right things With WileyPLUS, students always know the exact outcome of their efforts With increased confidence, motivation is sustained so students stay on task longer, leading to success FM.qxd 11/1/10 9:11 AM Page xi for Instructors What INSTRUCTORS receive with WileyPLUS? Support and Insight into Student Progress WileyPLUS provides reliable, customizable resources that reinforce course goals inside and outside of the classroom, as well as visibility into individual student progress Pre-created materials and activities help instructors optimize their time For class preparation and classroom use: · Lecture Notes, PowerPoint Slides, and Tutorials · Classroom Response System (Clicker) Questions · Image Gallery For assignments and testing: · Gradable Reading Assignment Questions (embedded with online text) · Question Assignments: all end-of-chapter problems coded algorithmically with hints, links to text For course planning: WileyPLUS comes with a pre-created Course Plan designed by a subject matter expert uniquely for this course Simple drag-and-drop tools make it easy to assign the course plan as-is or modify it to reflect your course syllabus For progress monitoring: WileyPLUS provides instant access to reports on trends in class performance, student use of course materials, and progress toward learning objectives, helping inform decisions and drive classroom discussions Experience WileyPLUS for effective teaching and learning at www.wileyplus.com Powered by proven technology and built on a foundation of cognitive research, WileyPLUS has enriched the education of millions of students, in over 20 countries around the world FM.qxd 11/1/10 9:11 AM Page xii The Wiley Faculty Network The Place Where Faculty Connect The Wiley Faculty Network is a global community of faculty connected by a passion for teaching and a drive to learn and share Connect with the Wiley Faculty Network to collaborate with your colleagues, find a mentor, attend virtual and live events, and view a wealth of resources all designed to help you grow as an educator Embrace the art of teaching—great things happen where faculty connect! Virtual Guest Lectures Discover innovative ideas and gain knowledge you can use • Training • Virtual Guest Lectures • Live Events Explore your resources and development opportunities • • • • Teaching Resources Archived Guest Lectures Recorded Presentations Professional Development Modules Connect with recognized leaders across disciplines and collaborate with your peers on timely topics and discipline specific issues, many of which offer CPE credit Live and Virtual Events These invitation-only, discipline-specific events are organized through a close partnership between the WFN, Wiley, and the academic community near the event location Technology Training Discover a wealth of topic- and technology-specific training presented by subject matter experts, authors, and faculty where and when you need it Teaching Resources Connect with colleagues— your greatest resource • Find a Mentor • Interest Groups • Blog Find out more at www.WHEREFACULTYCONNECT.com Propel your teaching and student learning to the next level with quality peer-reviewed case studies, testimonials, classroom tools, and checklists Connect with Colleagues Achieve goals and tackle challenges more easily by enlisting the help of your peers Connecting with colleagues through the WFN can help you improve your teaching experience c03TheAccountingInformationSystem.qxd 154 9/3/10 11:47 AM Page 154 chapter The Accounting Information System Problems: Set C Visit the book’s companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problem Set C Continuing Cookie Chronicle (Note: This is a continuation of the Cookie Chronicle from Chapters and 2.) CCC3 In November 2011, after having incorporated Cookie Creations Inc., Natalie begins operations She has decided not to pursue the offer to supply cookies to Biscuits Instead, she will focus on offering cooking classes The following events occur Nov 8 11 14 15 16 17 18 25 29 30 30 30 30 (c) Trial balance total 3,910 Natalie cashes in her U.S Savings Bonds and receives $520, which she deposits in her personal bank account Natalie opens a bank account for Cookie Creations Inc Natalie purchases $500 of Cookie Creations’ common stock Cookie Creations purchases paper and other office supplies for $95 (Use Supplies.) Cookie Creations pays $125 to purchase baking supplies, such as flour, sugar, butter, and chocolate chips (Use Supplies.) Natalie starts to gather some baking equipment to take with her when teaching the cookie classes She has an excellent top-of-the-line food processor and mixer that originally cost her $550 Natalie decides to start using it only in her new business She estimates that the equipment is currently worth $300, and she transfers the equipment into the business in exchange for additional common stock The company needs more cash to sustain its operations Natalie’s grandmother lends the company $2,000 cash, in exchange for a two-year, 9% note payable Interest and the principal are repayable at maturity Cookie Creations pays $900 for additional baking equipment Natalie schedules her first class for November 29 She will receive $100 on the date of the class Natalie books a second class for December for $150 She receives a $60 cash down payment, in advance Natalie teaches her first class, booked on November 18, and collects the $100 cash Natalie’s brother develops a website for Cookie Creations Inc that the company will use for advertising He charges the company $600 for his work, payable at the end of December (Because the website is expected to have a useful life of two years before upgrades are needed, it should be treated as an asset called Website.) Cookie Creations pays $1,200 for a one-year insurance policy Natalie teaches a group of elementary school students how to make Santa Claus cookies At the end of the class, Natalie leaves an invoice for $300 with the school principal The principal says that he will pass it along to the business office and it will be paid some time in December Natalie receives a $50 invoice for use of her cell phone She uses the cell phone exclusively for Cookie Creations Inc business The invoice is for services provided in November, and payment is due on December 15 Instructions (a) Prepare journal entries to record the November transactions (b) Post the journal entries to the general ledger accounts (c) Prepare a trial balance at November 30, 2011 c03TheAccountingInformationSystem.qxd 8/5/10 9:59 AM Page 155 Broadening Your Perspective broadening your perspective Financial Reporting and Analysis FINANCIAL REPORTING PROBLEM: Tootsie Roll Industries Inc BYP3-1 The financial statements of Tootsie Roll in Appendix A at the back of this book contain the following selected accounts, all in thousands of dollars Common Stock Accounts Payable Accounts Receivable Selling, Marketing, and Administrative Expenses Prepaid Expenses Net Property, Plant, and Equipment Net Product Sales $ 24,862 9,140 37,512 103,755 8,562 220,721 495,592 Instructions (a) What is the increase and decrease side for each account? What is the normal balance for each account? (b) Identify the probable other account in the transaction and the effect on that account when: (1) Accounts Receivable is decreased (2) Accounts Payable is decreased (3) Prepaid Expenses is increased (c) Identify the other account(s) that ordinarily would be involved when: (1) Interest Expense is increased (2) Property, Plant, and Equipment is increased COMPARATIVE ANALYSIS PROBLEM: Tootsie Roll vs Hershey BYP3-2 The financial statements of The Hershey Company appear in Appendix B, following the financial statements for Tootsie Roll in Appendix A Instructions (a) Based on the information contained in these financial statements, determine the normal balance for: Tootsie Roll Industries (1) (2) (3) (4) (5) Accounts Receivable Net Property, Plant, and Equipment Accounts Payable Retained Earnings Net Product Sales The Hershey Company (1) (2) (3) (4) (5) Inventories Provision for Income Taxes Accrued Liabilities Common Stock Interest Expense (b) Identify the other account ordinarily involved when: (1) Accounts Receivable is increased (2) Notes Payable is decreased (3) Machinery is increased (4) Interest Revenue is increased RESEARCH CASE BYP3-3 Sid Cato provides critiques of corporate annual reports He maintains a website at www.sidcato.com that provides many useful resources for those who are interested in preparing or using annual reports Instructions Go to the website and answer the following questions (a) Read the section, “What makes a good annual report?” and choose which three factors you think are most important Explain why you think each item is important (b) For the most recent year presented, which companies were listed in the section “Producers of the best annuals for (most recent year)”? (c) What potential benefits might a company gain by receiving a high rating from Sid Cato’s organization? 155 c03TheAccountingInformationSystem.qxd 156 8/3/10 1:33 PM Page 156 chapter The Accounting Information System INTERPRETING FINANCIAL STATEMENTS BYP3-4 Chieftain International, Inc., is an oil and natural gas exploration and production company A recent balance sheet reported $208 million in assets with only $4.6 million in liabilities, all of which were short-term accounts payable During the year, Chieftain expanded its holdings of oil and gas rights, drilled 37 new wells, and invested in expensive 3-D seismic technology The company generated $19 million cash from operating activities and paid no dividends It had a cash balance of $102 million at the end of the year Instructions (a) Name at least two advantages to Chieftain from having no long-term debt Can you think of disadvantages? (b) What are some of the advantages to Chieftain from having this large a cash balance? What is a disadvantage? (c) Why you suppose Chieftain has the $4.6 million balance in accounts payable, since it appears that it could have made all its purchases for cash? FINANCIAL ANALYSIS ON THE WEB BYP3-5 Purpose: This activity provides information about career opportunities for CPAs Address: www.icpas.org, or go to www.wiley.com/college/kimmel Steps Go to the address shown above and click on Students/Educators Click on High School, then CPA101 for parts a, b, and c Click College to answer part d Instructions Answer the following questions (a) What does CPA stand for? Where CPAs work? (b) What is meant by “public accounting”? (c) What skills does a CPA need? (d) What is the salary range for a CPA at a large firm during the first three years? What is the salary range for chief financial officers and treasurers at large corporations? Critical Thinking DECISION MAKING ACROSS THE ORGANIZATION BYP3-6 Donna Dye operates Double D Riding Academy, Inc The academy’s primary sources of revenue are riding fees and lesson fees, which are provided on a cash basis Donna also boards horses for owners, who are billed monthly for boarding fees In a few cases, boarders pay in advance of expected use For its revenue transactions, the academy maintains these accounts: Cash, Accounts Receivable, Unearned Revenue, Riding Revenue, Lesson Revenue, and Boarding Revenue The academy owns 10 horses, a stable, a riding corral, riding equipment, and office equipment These assets are accounted for in the following accounts: Horses, Building, Riding Corral, Riding Equipment, and Office Equipment The academy employs stable helpers and an office employee, who receive weekly salaries At the end of each month, the mail usually brings bills for advertising, utilities, and veterinary service Other expenses include feed for the horses and insurance For its expenses, the academy maintains the following accounts: Hay and Feed Supplies, Prepaid Insurance, Accounts Payable, Salaries Expense, Advertising Expense, Utilities Expense, Veterinary Expense, Hay and Feed Expense, and Insurance Expense Donna Dye’s sole source of personal income is dividends from the academy Thus, the corporation declares and pays periodic dividends To account for stockholders’ equity in the business and dividends, two accounts are maintained: Common Stock and Dividends During the first month of operations an inexperienced bookkeeper was employed Donna Dye asks you to review the following eight entries of the 50 entries made during the month In each case, the explanation for the entry is correct c03TheAccountingInformationSystem.qxd 8/3/10 1:33 PM Page 157 Broadening Your Perspective May 14 15 20 31 Cash Unearned Revenue (Issued common stock in exchange for $15,000 cash) Cash Lesson Revenue (Received $250 cash for lesson fees) Cash Boarding Revenue (Received $500 for boarding of horses beginning June 1) Hay and Feed Expense Cash (Purchased estimated months’ supply of feed and hay for $1,500 on account) Riding Equipment Cash (Purchased desk and other office equipment for $800 cash) Salaries Expense Cash (Issued check to Donna Dye for personal use) Cash Riding Revenue (Received $154 cash for riding fees) Veterinary Expense Accounts Receivable (Received bill of $75 from veterinarian for services provided) 15,000 15,000 250 250 500 500 1,500 1,500 80 800 400 400 145 154 75 75 Instructions With the class divided into groups, answer the following (a) For each journal entry that is correct, so state For each journal entry that is incorrect, prepare the entry that should have been made by the bookkeeper (b) Which of the incorrect entries would prevent the trial balance from balancing? (c) What was the correct net income for May, assuming the bookkeeper originally reported net income of $4,500 after posting all 50 entries? (d) What was the correct cash balance at May 31, assuming the bookkeeper reported a balance of $12,475 after posting all 50 entries? COMMUNICATION ACTIVITY BYP3-7 Clean Sweep Company offers home cleaning service Two recurring transactions for the company are billing customers for services provided and paying employee salaries For example, on March 15 bills totaling $6,000 were sent to customers, and $2,000 was paid in salaries to employees Instructions Write a memorandum to your instructor that explains and illustrates the steps in the recording process for each of the March 15 transactions Use the format illustrated in the text under the heading “The Recording Process Illustrated” (pp 121–126) ETHICS CASES BYP3-8 Courtney Delacey is the assistant chief accountant at BIT Company, a manufacturer of computer chips and cellular phones The company presently has total sales of $20 million It is the end of the first quarter and Courtney is hurriedly trying to prepare a general ledger trial balance so that quarterly financial statements can be prepared and released to management and the regulatory agencies The total credits on the trial balance exceed the debits by $1,000 157 c03TheAccountingInformationSystem.qxd 158 8/3/10 1:33 PM Page 158 chapter The Accounting Information System In order to meet the P.M deadline, Courtney decides to force the debits and credits into balance by adding the amount of the difference to the Equipment account She chose Equipment because it is one of the larger account balances; percentage-wise it will be the least misstated Courtney plugs the difference! She believes that the difference is quite small and will not affect anyone’s decisions She wishes that she had another few days to find the error but realizes that the financial statements are already late Instructions (a) Who are the stakeholders in this situation? (b) What ethical issues are involved? (c) What are Courtney’s alternatives? BYP3-9 The July 28, 2007, issue of the Wall Street Journal includes an article by Kathryn Kranhold entitled “GE’s Accounting Draws Fresh Focus on News of Improper Sales Bookings.” Instructions Read the article and answer the following questions (a) What improper activity did the employees at GE engage in? (b) Why might the employees have engaged in this activity? (c) What were the implications for the employees who engaged in this activity? (d) What does it mean to “restate” financial results? Why didn’t GE restate its results to correct for the improperly reported locomotive sales? “ALL ABOUT YOU” ACTIVITY BYP3-10 In their annual reports to stockholders, companies must report or disclose information about all liabilities, including potential liabilities related to environmental clean-up There are many situations in which you will be asked to provide personal financial information about your assets, liabilities, revenue, and expenses Sometimes you will face difficult decisions regarding what to disclose and how to disclose it Instructions Suppose that you are putting together a loan application to purchase a home Based on your income and assets, you qualify for the mortgage loan, but just barely How would you address each of the following situations in reporting your financial position for the loan application? Provide responses for each of the following questions (a) You signed a guarantee for a bank loan that a friend took out for $20,000 If your friend doesn’t pay, you will have to pay Your friend has made all of the payments so far, and it appears he will be able to pay in the future (b) You were involved in an auto accident in which you were at fault There is the possibility that you may have to pay as much as $50,000 as part of a settlement The issue will not be resolved before the bank processes your mortgage request (c) The company at which you work isn’t doing very well, and it has recently laid off employees You are still employed, but it is quite possible that you will lose your job in the next few months Answers to Insight and Accounting Across the Organization Questions p 109 Why Accuracy Matters Q: In order for these companies to prepare and issue financial statements, their accounting equations (debit and credits) must have been in balance at year-end How could these errors or misstatements have occurred? A: A company’s accounting equation (its books) can be in balance yet its financial statements have errors or misstatements because of the following: entire transactions were not recorded; transactions were recorded at wrong amounts; transactions were recorded in the wrong accounts; transactions were recorded in the wrong accounting period Audits of financial statements uncover some, but obviously not all, errors or misstatements p 115 Keeping Score Q: Do you think that the Chicago Bears football team would be likely to have the same major revenue and expense accounts as the Cubs? A: Because their businesses are similar—professional sports—many of the revenue and expense accounts for the baseball and football teams might be similar p 119 Boosting Microsoft’s Profits Q: In what ways is this Microsoft division using accounting to assist in its effort to become more profitable? A: The division has used accounting to set very strict sales, revenue, and profit goals In addition, the managers in this division use accounting c03TheAccountingInformationSystem.qxd 8/3/10 1:33 PM Page 159 A Look at IFRS to keep a tight reign on product costs Also, accounting serves as the basis of communication so that the marketing managers and product designers can work with production managers, engineers, and accountants to create an exciting product within specified cost constraints Answers to Self-Test Questions b b b a (Ϫ$50,000 ϭ Ϫ$90,000 ϩ $40,000) 12 c 13 d 14 a 15 c IFRS b c d d d 10 b 11 a A Look at IFRS International companies use the same set of procedures and records to keep track of transaction data Thus, the material in Chapter dealing with the account, general rules of debit and credit, and steps in the recording process—the journal, ledger, and chart of accounts—is the same under both GAAP and IFRS KEY POINTS • Transaction analysis is the same under IFRS and GAAP but, as you will see in later chapters, different standards sometimes impact how transactions are recorded • Rules for accounting for specific events sometimes differ across countries For example, European companies rely less on historical cost and more on fair value than U.S companies Despite the differences, the double-entry accounting system is the basis of accounting systems worldwide • Both the IASB and FASB go beyond the basic definitions provided in this textbook for the key elements of financial statements, that is, assets, liabilities, equity, revenues, and expenses The more substantive definitions, using the IASB definitional structure, are provided in the Chapter A Look at IFRS discussion • A trial balance under IFRS follows the same format as shown in the textbook • As shown in the textbook, dollars signs are typically used only in the trial balance and the financial statements The same practice is followed under IFRS, using the currency of the country that the reporting company is headquartered • In February 2010, the SEC expressed a desire to continue working toward a single set of highquality standards In deciding whether the United States should adopt IFRS, some of the issues the SEC said should be considered are: ◆ Whether IFRS is sufficiently developed and consistent in application ◆ Whether the IASB is sufficiently independent ◆ Whether IFRS is established for the benefit of investors ◆ The issues involved in educating investors about IFRS ◆ The impact of a switch to IFRS on U.S laws and regulations ◆ The impact on companies including changes to their accounting systems, contractual arrangements, corporate governance, and litigation ◆ The issues involved in educating accountants, so they can prepare statements under IFRS LOOKING TO THE FUTURE The basic recording process shown in this textbook is followed by companies across the globe It is unlikely to change in the future The definitional structure of assets, liabilities, equity, revenues, and expenses may change over time as the IASB and FASB evaluate their overall conceptual framework for establishing accounting standards 159 c03TheAccountingInformationSystem.qxd 160 8/3/10 1:33 PM Page 160 chapter The Accounting Information System IFRS Self-Test Questions Which statement is correct regarding IFRS? (a) IFRS reverses the rules of debits and credits, that is, debits are on the right and credits are on the left (b) IFRS uses the same process for recording transactions as GAAP (c) The chart of accounts under IFRS is different because revenues follow assets (d) None of the above statements are correct The expanded accounting equation under IFRS is as follows: (a) Assets ϭ Liabilities ϩ Share Capital ϩ Dividends ϩ Revenues Ϫ Expenses (b) Assets ϩ Liabilities ϭ Share Capital ϩ Dividends ϩ Revenues Ϫ Expenses (c) Assets ϭ Liabilities ϩ Share Capital Ϫ Dividends ϩ Revenues Ϫ Expenses (d) Assets ϭ Liabilities ϩ Share Capital ϩ Dividends Ϫ Revenues Ϫ Expenses A trial balance: (a) is the same under IFRS and GAAP (b) proves that transactions are recorded correctly (c) proves that all transactions have been recorded (d) will not balance if a correct journal entry is posted twice One difference between IFRS and GAAP is that: (a) GAAP uses accrual-accounting concepts and IFRS uses primarily the cash basis of accounting (b) IFRS uses a different posting process than GAAP (c) IFRS uses more fair value measurements than GAAP (d) the limitations of a trial balance are different between IFRS and GAAP The general policy for using proper currency signs (dollar, yen, pound, etc.) is the same for both IFRS and this textbook This policy is as follows: (a) Currency signs only appear in ledgers and journal entries (b) Currency signs are only shown in the trial balance (c) Currency signs are shown for all compound journal entries (d) Currency signs are shown in trial balances and financial statements IFRS Concepts and Application IFRS3–1 Describe some of the issues the SEC must consider in deciding whether the United States should adopt IFRS INTERNATIONAL FINANCIAL REPORTING PROBLEM: Zetar plc IFRS3–2 The financial statements of Zetar plc are presented in Appendix C The company’s complete annual report, including the notes to its financial statements, is available at www.zetarplc.com Instructions Describe in which statement each of the following items is reported, and the position in the statement (e.g., current asset) (a) Share capital (b) Goodwill (c) Borrowings and overdrafts (d) Amortisation of intangible assets (e) Derivative financial asset Answers to IFRS Self-Test Questions b ✓ ● ● c a c d Remember to go back to the navigator box on the chapter opening page and check off your completed work c03TheAccountingInformationSystem.qxd 8/3/10 1:33 PM Page 161 c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 162 chapter ACCRUAL ACCOUNTING CONCEPTS ✓ ● the navigator ● Scan Study Objectives ● Read Feature Story ● Scan Preview ● Read Text and Answer Do it! p 175 p 180 p 185 After studying this chapter, you should be able to: p 189 ● Work Using the Decision Toolkit ● Review Summary of Study Objectives ● Work Comprehensive Do it! p 197 ● Answer Self-Test Questions ● Complete Assignments ● Go to WileyPLUS for practice and tutorials ● 162 study objectives Read A Look at IFRS p 224 Explain the revenue recognition principle and the expense recognition principle Differentiate between the cash basis and the accrual basis of accounting Explain why adjusting entries are needed, and identify the major types of adjusting entries Prepare adjusting entries for deferrals Prepare adjusting entries for accruals Describe the nature and purpose of the adjusted trial balance Explain the purpose of closing entries Describe the required steps in the accounting cycle Understand the causes of differences between net income and cash provided by operating activities c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 163 feature story The accuracy of the financial reporting system de- most common abuses of financial accounting Xerox pends on answers to a few fundamental questions At admitted reporting billions of dollars of lease revenue what point has revenue been earned? At what point in periods earlier than it should have been reported is the earnings process complete? When have ex- And WorldCom stunned the financial markets with its penses really been incurred? admission that it had boosted net income by billions During the 1990s, the stock prices of dot-com companies boomed Many dot-com companies earned most of their revenue from selling advertising space on their websites To boost reported revenue, some dot-coms began swapping website ad space Company of dollars by delaying the recognition of expenses until later years W HAT WAS YO U R P R O FIT? Unfortunately, revelations such as these have become all too common in the corporate world It is no wonder that the U.S Trust Survey of affluent Ameri- A would put an ad for its website on company B’s web- cans reported that 85 percent of its respondents be- site, and company B would put an ad for its website on lieved that there should be tighter regulation of finan- company A’s website No money ever changed hands, cial disclosures, and 66 percent said they did not trust but each company recorded revenue (for the value of the management of publicly traded companies the space that it gave up on its site) This practice did Why did so many companies violate basic financial little to boost net income and resulted in no additional reporting rules and sound ethics? Many speculate that cash flow—but it did boost reported revenue Regula- as stock prices climbed, executives were under increas- tors eventually put an end to the practice ing pressure to meet higher and higher earnings expec- Another type of transgression results from compa- tations If actual results weren’t as good as hoped for, nies recording revenue or expenses in the wrong year some gave in to temptation and “adjusted” their num- In fact, shifting revenues and expenses is one of the bers to meet market expectations INSIDE CHAPTER ● ● ● ● Cooking the Books? (p 166) Reporting Revenue Accurately (p 167) Turning Gift Cards into Revenue (p 174) Cashing In on Accrual Accounting (p 178) 163 c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 164 preview of chapter As indicated in the Feature Story, making adjustments is necessary to avoid misstatement of revenues and expenses such as those at Xerox and WorldCom In this chapter, we introduce you to the accrual accounting concepts that make such adjustments possible The organization and content of the chapter are as follows Accrual Accounting Concepts The Basics of Adjusting Entries Timing Issues • Revenue recognition principle • Expense recognition principle • Accrual versus cash basis of accounting • Types of adjusting entries • Adjusting entries for deferrals • Adjusting entries for accruals • Summary of basic relationships The Adjusted Trial Balance and Financial Statements • Preparing the adjusted trial balance • Preparing financial statements Closing the Books • Preparing closing entries • Preparing a postclosing trial balance • Summary of the accounting cycle Quality of Earnings • Earnings management • Sarbanes-Oxley Timing Issues study objective Explain the revenue recognition principle and the expense recognition principle Helpful Hint An accounting time period that is one year long is called a fiscal year Revenue Recognition Service performed Customer requests service Cash received Revenue should be recognized in the accounting period in which it is earned (generally when service is performed) 164 Most businesses need immediate feedback about how well they are doing For example, management usually wants monthly reports on financial results, most large corporations are required to present quarterly and annual financial statements to stockholders, and the Internal Revenue Service requires all businesses to file annual tax returns Accounting divides the economic life of a business into artificial time periods As indicated in Chapter 2, this is the periodicity assumption Accounting time periods are generally a month, a quarter, or a year Many business transactions affect more than one of these arbitrary time periods For example, a new building purchased by Citigroup or a new airplane purchased by Delta Air Lines will be used for many years It doesn’t make sense to expense the full cost of the building or the airplane at the time of purchase because each will be used for many subsequent periods Instead, we determine the impact of each transaction on specific accounting periods Determining the amount of revenues and expenses to report in a given accounting period can be difficult Proper reporting requires an understanding of the nature of the company’s business Two principles are used as guidelines: the revenue recognition principle and the expense recognition principle THE REVENUE RECOGNITION PRINCIPLE The revenue recognition principle requires that companies recognize revenue in the accounting period in which it is earned In a service company, revenue is considered to be earned at the time the service is performed To illustrate, assume Conrad Dry Cleaners cleans clothing on June 30, but customers not claim and pay for their clothes until the first week of July Under the revenue recognition principle, Conrad earns revenue in June when it performs the service, not in July when it receives the cash At June 30, Conrad would report a receivable on its balance sheet and revenue in its income statement for the service performed The journal entries for June and July would be as follows c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 165 Timing Issues June July Accounts Receivable Service Revenue xxx Cash Accounts Receivable xxx 165 xxx xxx DECISION TOOLKIT DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION At what point should the company record revenue? Need to understand the nature of the company’s business Record revenue when earned A service business earns revenue when it performs a service HOW TO EVALUATE RESULTS Recognizing revenue too early overstates current period revenue; recognizing it too late understates current period revenue THE EXPENSE RECOGNITION PRINCIPLE In recognizing expenses, a simple rule is followed: “Let the expenses follow the revenues.” Thus, expense recognition is tied to revenue recognition Applied to the preceding example, this means that the salary expense Conrad incurred in performing the cleaning service on June 30 should be reported in the same period in which it recognizes the service revenue The critical issue in expense recognition is determining when the expense makes its contribution to revenue This may or may not be the same period in which the expense is paid If Conrad does not pay the salary incurred on June 30 until July, it would report salaries payable on its June 30 balance sheet The practice of expense recognition is referred to as the expense recognition principle (often referred to as the matching principle) It dictates that efforts (expenses) be matched with results (revenues) Illustration 4-1 shows these relationships Illustration 4-1 GAAP relationships in revenue and expense recognition Periodicity Assumption Economic life of business can be divided into artificial time periods Revenue Recognition Principle Expense Recognition Principle Revenue recognized in the accounting period in which it is earned Expenses matched with revenues in the period when efforts are expended to generate revenues Revenue and Expense Recognition In accordance with generally accepted accounting principles (GAAP) c04AccrualAccountingConcepts.qxd 166 8/3/10 1:50 PM Page 166 chapter Accrual Accounting Concepts DECISION TOOLKIT DECISION CHECKPOINTS INFO NEEDED FOR DECISION TOOL TO USE FOR DECISION At what point should the company record expenses? Need to understand the nature of the company’s business Expenses should “follow” revenues—that is, match the effort (expense) with the result (revenue) HOW TO EVALUATE RESULTS Recognizing expenses too early overstates current period expense; recognizing them too late understates current period expense Ethics Insight Cooking the Books? Allegations of abuse of the revenue recognition principle have become all too common in recent years For example, it was alleged that Krispy Kreme sometimes doubled the number of doughnuts shipped to wholesale customers at the end of a quarter to boost quarterly results The customers shipped the unsold doughnuts back after the beginning of the next quarter for a refund Conversely, Computer Associates International was accused of backdating sales—that is, saying that a sale that occurred at the beginning of one quarter occurred at the end of the previous quarter in order to achieve the previous quarter’s sales targets ? study objective Differentiate between the cash basis and the accrual basis of accounting International Note Although different accounting standards are often used by companies in other countries, the accrual basis of accounting is central to all of these standards What motivates sales executives and finance and accounting executives to participate in activities that result in inaccurate reporting of revenues? (See page 223.) ACCRUAL VERSUS CASH BASIS OF ACCOUNTING Accrual-basis accounting means that transactions that change a company’s financial statements are recorded in the periods in which the events occur, even if cash was not exchanged For example, using the accrual basis means that companies recognize revenues when earned (the revenue recognition principle), even if cash was not received Likewise, under the accrual basis, companies recognize expenses when incurred (the expense recognition principle), even if cash was not paid An alternative to the accrual basis is the cash basis Under cash-basis accounting, companies record revenue only when cash is received They record expense only when cash is paid The cash basis of accounting is prohibited under generally accepted accounting principles Why? Because it does not record revenue when earned, thus violating the revenue recognition principle Similarly, it does not record expenses when incurred, which violates the expense recognition principle Illustration 4-2 compares accrual-based numbers and cash-based numbers Suppose that Fresh Colors paints a large building in 2011 In 2011, it incurs and pays total expenses (salaries and paint costs) of $50,000 It bills the customer $80,000, but does not receive payment until 2012 On an accrual basis, Fresh Colors reports $80,000 of revenue during 2011 because that is when it is earned The company matches expenses of $50,000 to the $80,000 of revenue Thus, 2011 net income is $30,000 ($80,000 Ϫ $50,000) The $30,000 of net income reported for 2011 indicates the profitability of Fresh Colors’ efforts during that period If, instead, Fresh Colors were to use cash-basis accounting, it would report $50,000 of expenses in 2011 and $80,000 of revenues during 2012 As shown in Illustration 4-2, it would report a loss of $50,000 in 2011 and would report net income of $80,000 in 2012 Clearly, the cash-basis measures are misleading because the financial performance of the company would be misstated for both 2011 and 2012 c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 167 The Basics of Adjusting Entries 167 Illustration 4-2 Accrualversus cash-basis accounting 2011 Bob's Bait B arn arn Bob's Bait B Fresh Colors P AIN T P AIN T P $ Bob's Bait Barn $ Activity 2012 AIN T Purchased paint, painted building, paid employees Accrual basis Revenue Expense Net income Cash basis Revenue Expense Net loss $80,000 50,000 $30,000 $ 50,000 $( 50,000 ) Received payment for work done in 2011 Revenue Expense Net income $ Revenue Expense Net income $80,000 $80,000 $ 0 Investor Insight Reporting Revenue Accurately Until recently, electronics manufacturer Apple was required to spread the revenues earned from iPhone sales over the two-year period following the sale of the phone Accounting standards required this because it was argued that Apple was obligated to provide software updates after the phone was sold Therefore, since Apple had service obligations after the initial date of sale, it was forced to spread the revenue over a two-year period However, since the company received full payment upfront, the cash flows from iPhones significantly exceeded the revenue reported from iPhone sales in each accounting period It also meant that the rapid growth of iPhone sales was not fully reflected in the revenue amounts reported in Apple’s income statement A new accounting standard now enables Apple to report nearly all of its iPhone revenue at the point of sale It was estimated that 2009 revenues would have been about 17% higher, and earnings per share would have been almost 50% higher, under the new rule ? In the past, why was it argued that Apple should spread the recognition of iPhone revenue over a two-year period, rather than recording it upfront? (See page 223.) The Basics of Adjusting Entries In order for revenues to be recorded in the period in which they are earned, and for expenses to be recognized in the period in which they are incurred, companies make adjusting entries Adjusting entries ensure that the revenue recognition and expense recognition principles are followed Adjusting entries are necessary because the trial balance—the first pulling together of the transaction data—may not contain up-to-date and complete data This is true for several reasons: Some events are not recorded daily because it is not efficient to so Examples are the use of supplies and the earning of wages by employees study objective Explain why adjusting entries are needed, and identify the major types of adjusting entries c04AccrualAccountingConcepts.qxd 168 8/3/10 1:50 PM Page 168 chapter Accrual Accounting Concepts International Note Internal controls are a system of checks and balances designed to detect and prevent fraud and errors The Sarbanes-Oxley Act requires U.S companies to enhance their systems of internal control However, many foreign companies not have to meet strict internal control requirements Some U.S companies believe that this gives foreign firms an unfair advantage because developing and maintaining internal controls can be very expensive Illustration 4-3 Categories of adjusting entries Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions Examples are charges related to the use of buildings and equipment, rent, and insurance Some items may be unrecorded An example is a utility service bill that will not be received until the next accounting period Adjusting entries are required every time a company prepares financial statements The company analyzes each account in the trial balance to determine whether it is complete and up to date for financial statement purposes Every adjusting entry will include one income statement account and one balance sheet account TYPES OF ADJUSTING ENTRIES Adjusting entries are classified as either deferrals or accruals As Illustration 4-3 shows, each of these classes has two subcategories Deferrals: Prepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed Unearned revenues: Cash received and recorded as liabilities before revenue is earned Accruals: Accrued revenues: Revenues earned but not yet received in cash or recorded Accrued expenses: Expenses incurred but not yet paid in cash or recorded Subsequent sections give examples of each type of adjustment Each example is based on the October 31 trial balance of Sierra Corporation, from Chapter 3, reproduced in Illustration 4-4 Note that Retained Earnings, with a zero balance, has been added to this trial balance We will explain its use later Illustration 4-4 balance Trial SIERRA CORPORATION Trial Balance October 31, 2012 Debit Cash Supplies Prepaid Insurance Equipment Notes Payable Accounts Payable Unearned Service Revenue Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Rent Expense Credit $15,200 2,500 600 5,000 $ 5,000 2,500 1,200 10,000 500 10,000 4,000 900 $28,700 $28,700 We assume that Sierra Corporation uses an accounting period of one month Thus, monthly adjusting entries are made The entries are dated October 31 ... Responsibility Accounting for Profit Centers 1097 Responsibility Accounting for Investment Centers 1099 Principles of Performance Evaluation 1102 APPENDIX 21A Residual Income—Another Performance Measurement... Financial Statements The Accounting Information System 100 Knowing the Numbers Forms of Business Organization Internal Users External Users Ethics in Financial Reporting Business Activities Financing... and Analyzing Investments E-1 F Payroll Accounting F-1 *G Subsidiary Ledgers and Special Journals G-1 *H Accounting for Partnerships H-1 *I Accounting for Sole Proprietorships I-1 *Available